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Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates

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  • Gurdip Bakshi
  • Dilip Madan
  • Frank Zhang
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    Abstract

    This article presents a framework for modeling defaultable debt under alternative recovery conventions (for a wide class of processes describing recovery rates and default probability). These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be utilized to invert the market expectation of recovery rates implicit in bond prices. Among potential applications, the framework can be used for pricing and hedging credit derivatives that are contingent on the default event and/or recovery levels. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices. This article has attempted to model recovery and comprehend their impact on debt values.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2001-37.

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    Date of creation: 2001
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    Handle: RePEc:fip:fedgfe:2001-37

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    Related research

    Keywords: Credit ; Risk ; Econometric models;

    This paper has been announced in the following NEP Reports:

    References

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    1. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
    2. Hua He, 2000. "Modeling Term Structures of Swap Spreads," Yale School of Management Working Papers ysm150, Yale School of Management, revised 01 Mar 2001.
    3. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
    4. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
    5. Pierre Collin-Dufresne, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, vol. 56(3), pages 1095-1115, 06.
    6. Gurdip Bakshi & Nikunj Kapadia & Dilip Madan, 2003. "Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 101-143.
    7. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
    8. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    9. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
    10. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
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    Cited by:
    1. Pesaran, M. Hashem & Schuermann, Til & Treutler, Bjorn-Jakob & Weiner, Scott M., 2006. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1211-1261, August.
    2. Frank X. Zhang, 2003. "What did the credit market expect of Argentina default? Evidence from default swap data," Finance and Economics Discussion Series 2003-25, Board of Governors of the Federal Reserve System (U.S.).
    3. Jochen R. Andritzky, 2004. "Implied Default Probabilities and Default Recovery Ratios: An Analysis of Argentine Eurobonds 2000-2002," Econometric Society 2004 Far Eastern Meetings 500, Econometric Society.
    4. Klaus Rheinberger & Martin Summer, 2008. "Credit portfolio risk and asset price cycles," Computational Management Science, Springer, vol. 5(4), pages 337-354, October.
    5. Houweling, Patrick & Vorst, Ton, 2005. "Pricing default swaps: Empirical evidence," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1200-1225, December.
    6. Jochen R. Andritzky & Manmohan Singh, 2005. "Overpricing in Emerging Market Credit-Default-Swap Contracts: Some Evidence from Recent Distress Cases," IMF Working Papers 05/125, International Monetary Fund.
    7. Robert Jarrow & Vikrant Tyagi, 2007. "Tax liens: a novel application of asset pricing theory," Review of Derivatives Research, Springer, vol. 10(2), pages 181-204, May.
    8. Chen, Ren-Raw & Cheng, Xiaolin & Liu, Bo, 2008. "Estimation and evaluation of the term structure of credit default swaps: An empirical study," Insurance: Mathematics and Economics, Elsevier, vol. 43(3), pages 339-349, December.

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